Unlocking the QSBS Advantage: A Founder’s Guide to Tax-Free Gains and Legacy Planning

To read the article on our website, please click here

What is QSBS?

QSBS refers to shares in a Qualified Small Business (QSB) that meet specific requirements set by the IRS. These shares must be issued by a U.S. C-corporation with assets of $50 million or less at issuance and held for at least five years. QSBS allows for significant tax savings by potentially excluding up to 100% of capital gains on the sale of the stock, up to a certain limit.

Key Benefits of QSBS for Founders

Major Capital Gains Tax Exemption

• Up to 100% Exemption: Founders and investors can exclude up to 100% of capital gains on the sale of QSBS, making it one of the most significant tax breaks for early-stage company stakeholders.
• Exemption Cap: The exclusion has a cap, which is the greater of $10 million or ten times the adjusted tax basis of the investment, allowing for significant tax savings on potentially large exit events
• Encouragement for Startups: QSBS aims to incentivize investments in small businesses by lowering the tax burden on successful exits, making it easier for founders to attract and reward early-stage investors.

Estate and Trust Planning Advantages

• Gift Tax and Estate Planning: Founders can transfer QSBS shares to heirs or trusts, passing along the capital gains exemption. This makes QSBS an effective tool for reducing future tax liabilities on estate transfers.Strategic Tax Planning: Transferring QSBS shares to trusts may "restart" the five-year holding period, potentially creating multiple opportunities for tax exemption across various beneficiaries. Founders can utilize family trusts to transfer wealth to the next generation with minimal tax consequences.

Enhanced Investor Appeal

• QSBS rules increase the appeal of early-stage investments by allowing angel investors and venture capitalists to capture higher post-tax returns. Founders benefit because a more attractive tax profile for investors can help in securing funding.

Requirements for QSBS Eligibility

To fully leverage the QSBS tax benefits, founders must ensure compliance with specific IRS requirements:

1. Qualified Small Business Status: The company must be a domestic C-corporation with gross assets of $50 million or less at all times before and immediately after the issuance of the stock. The company must actively engage in qualified trade or business. Certain industries, including finance, real estate, and professional services, do not qualify. The company must use at least 80% of its assets in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period. The stock must be acquired after September 27, 2010, to benefit from the full exemption. However, the exemption will be capped at 75% if the stock was acquired between February 18, 2009, and September 27, 2010, or at 50% if the stock was acquired between August 11, 1993, and February 17, 2009. Stock issued before August 11, 1993, does not currently qualify for QSBS exemption.
2. Five-Year Holding Period: QSBS shares must be held for at least five years to qualify for the full capital gains exclusion. Selling before five years could disqualify the shares unless a specific exemption, like a rollover, is applied.
3. Original Issuance Requirement: QSBS must be acquired at its original issuance—meaning directly from the company—by the taxpayer in exchange for money, property (not stock), or as compensation for services.
4. Compliance with Ongoing Requirements: The company must continue to qualify as a small business throughout the holding period. This means it must maintain asset limits and avoid disqualifying activities at all times before and immediately after the issuance of the stock. If the company’s total assets exceed $50 million at any time after issuance, it can still qualify as a QSB as long as it met the asset limit when the stock was initially issued.

Strategic Uses of QSBS for Founders and Tax Planning

1. Estate and Trust Planning

• Founders can leverage QSBS in estate planning by transferring shares to family members, heirs, or trusts, thereby maximizing the tax exclusion benefits across generations. By placing shares in multiple trusts, each trust can potentially qualify for its own QSBS exclusion, multiplying the tax benefits. This allows founders to pass on more wealth to beneficiaries with minimal tax impact.

1. Stacking Exemptions

• Founders and investors may employ a "stacking" strategy by distributing QSBS across multiple family members or trusts. Each family member or trust can claim the $10 million (or ten times the basis) exclusion, effectively multiplying the tax benefits. For example, if a founder’s stock is transferred to three trusts for their children, each trust can independently claim the exclusion, thus creating a larger overall tax-free benefit.

1. Early Tax Planning for Startups

• Founders should prioritize QSBS eligibility during the company formation phase by setting up as a C-corporation. To retain this status, founders should work with advisors to monitor asset levels and business activities to prevent accidental disqualification. Strategic planning early on allows for greater flexibility and optimization of QSBS benefits over time.

The Importance of External Valuation for IRS 1202 Compliance and Choosing the Right Valuation Provider

To qualify for the Qualified Small Business Stock (QSBS) benefits under IRS Section 1202, one key requirement is maintaining the company’s gross asset threshold of $50 million or less. This requires careful monitoring and documentation of the company's financials, including an external valuation to substantiate compliance at the time of stock issuance. An independent valuation ensures that gross assets—defined as the total assets reflected on the company’s balance sheet plus proceeds from stock issuance—are accurately assessed and in line with IRS guidelines.

For founders and CFOs, choosing a valuation provider with expertise in QSBS-specific requirements is essential. Beyond asset thresholds, the provider should offer insights into other critical elements such as stock issuance timing, original issuance standards, and the interplay of venture funding events on QSBS eligibility. Founders should also consider providers experienced in navigating the unique complexities of intellectual property valuation, which is often a significant component of tech startups’ asset base. Engaging a valuation partner early in the company’s lifecycle can streamline compliance, reduce risks, and optimize QSBS benefits during future funding rounds or exits.

Conclusion: Maximizing the Benefits of QSBS for Founders

QSBS presents a unique opportunity for founders to significantly reduce their tax liabilities, attract investors, and enhance estate planning strategies. By meeting eligibility requirements and planning strategically, founders can maximize QSBS benefits and secure a lasting financial legacy.

For founders seeking funding, retaining QSBS eligibility adds appeal for investors who value potential tax-free returns on their investments. Consulting with financial advisors or tax professionals is crucial to navigating the complexities of QSBS, making the most of its tax-saving potential, and securing a tax-efficient future for both the company and its stakeholders.

For questions or inquiries please contact:

Nancy Shao

Senior Vice President

nshao@houlihancapital.com

Nancy Shao is a Senior Vice President in Houlihan Capital’s Valuation and Financial Advisory Group. She has over seven years of financial advisory experience and has worked on a variety of financial consulting engagements, including fairness/solvency opinions, financial modeling, tax planning/financial reporting valuations, litigation support, and financial due diligence. Prior to joining Houlihan Capital, Ms. Shao spent five years with the Financial Consulting Services Group of Loop Capital Holdings, LLC, where she specialized in business valuation and financial due diligence. Previously, Ms. Shao was an Analyst in the Valuation and Modeling Group of KPMG Advisory.

Ms. Shao holds a Master’s degree in Public Finance from the University of Southern California and a Master of Science degree in Applied Mathematics from DePaul University. Ms. Shao is a CFA® Charterholder.